Shopping from the shorts pile

About a year ago I attended a broker hosted lunch with Harvey Norman’s Gerry Harvey.

The first question at the lunch was actually posed by Harvey himself. He wondered who was shorting his shares (ASX:HVN) and why there were so many (more than 20% of issued capital) registered as short sales at that time. He could not fathom what was going on or where the stock was coming from, for he was by far the largest shareholder and he wasn’t lending his shares to anyone.

Further, he noted that the share price was less than net tangible assets (NTA) per share. It seemed strange to him, and it seemed strange to me as I figured that about a third of the shares not held by Harvey were in fact being lent to parties to short.

The “shorting of stocks” phenomena is not unique to the Australian market, but I suspect that no other market in the world has a contribution regime like ours that supports the activities of funds that short stocks. The legislated superannuation contribution for all workers acts to drive a massive amount of funds into index managers, who then lend this stock into pools that are accessed by a variety of hedge funds. The Australian super pool ($1.8 trillion at the end of December 2013 quarter) now exceeds both the GDP of Australia and the market capitalisation of the equity market. That is great news for the country, but it has become an investment headache because it cannot be actively managed. Rather, it necessarily defaults to passive type investing through index linked funds. Looking forward, this problem will only get worse and so it will present a boom for many hedge fund managers who will see a growing pool of shares available for borrowing.

In passing, I note that the average Australian worker would not know that part of their long-term savings, held in Australian listed shares, is possibly lent into stock pools that are accessed by hedge funds. Further, workers do not directly consent to this diversion of their assets and arguably they are not fairly compensated for providing their shares for lending.

On reflection, Gerry Harvey was simply asking the questions that many in the financial services industry, whether they are a regulator or a participant, are too embarrassed to ask. Who is shorting a stock and who is lending it to them?

At the meeting referred to above, HVN was trading below $2 per share and so the shorting funds actually had excessively built up short positions that ultimately led to HVN recovering sharply over the next few months. Observers watching the shorting activities in HVN would have been misled if they perceived that hedge funds were correctly valuing HVN shares.

Top short positions today

Over the weekend I decided to peruse the short positions and lending pools of listed shares presented on the ASIC website. I did so to see if The Reject Shop Limited (ASX:TRS) was amongst them, because the stock has fallen so sharply into value that I was searching for a reason just like Gerry Harvey did a year ago.

Interestingly, I found that TRS has about 4.9% of its shares available to be shorted or that are actually short. Further, I came across some other interesting features in the list of the most shorted stocks as measured by their issued capital. The names are well known to investors and the largest are Cochlear Limited (ASX:COH), United Limited (ASX:UGL), Monadelphous Group Limited (ASX:MND), Myer Holdings Limited (ASX:MYR), Metcash Limited (ASX:MTS) and JB Hi-Fi Limited (ASX:JBH). The top 10 short positions all have lending pools that represent over 10% of the issued capital of each company. As such, TRS is not shown: it had 1,379,391 reported short positions at March 19, according to ASIC. To see the full ASIC list, click here.

Figure 1. Top 10 shorted securities as at 19 March 2014

Source: ASIC

In COH’s case, about 17% of its shares are available for shorting. The top 10 positions noted above amounts to over $2 billion in securities, and I would guess that the total lending pool for all stocks is a multiple of this – that is tens of billions of dollars.

This is a staggering amount of money that is openly speculated through the Australian market. In effect it creates leverage for many active funds that gain access to the pools by lending in their own positions. All of this facilitation is provided by international investment banks that also increase the pools of stocks held by accessing the holdings of foreign participants.

TRS now in buy territory on a two-year view

As noted above, TRS has about 4.9 % of its shares available for shorting and given the trends of shorting activity and my reading of broker research, it would not surprise me to find that this level increases in coming months. However, what most shorting funds are doing is to take a short-term view on price rather than a longer-term view on value. Further, and importantly, they often fail to understand that businesses are perpetual entities that grow, stagger, recover and/or re-emerge. There is nothing static about business. In the case of TRS, the question is what and when change will take effect.

In my last commentary on TRS in February, I suggested that value investors should look at this stock at below $10 following its very poor half-year result. I suggested that the company had grown too quickly and the falling profitability, following the recent capital raising, was a cause for concern that needed to be addressed. Recently the managing director of TRS resigned, and I am speculating when I suggest that new management will be charged with the object of lifting profitability back to a more acceptable and historic level. Time will tell, but rarely do investors get an opportunity to buy a quality business at such a significant discount to value based on a benign view on recovery.

So what is TRS worth?

To answer this question, it is important to look forward and assume that TRS should report an improved result in 2014-15 as measured by profit growth and profitability (or NROE, normalised return on equity). Companies must constantly seek to improve performance and it would be folly to assume that the TRS board and new management will not adjust the business going forward to generate higher returns.

The last 12 months has seen a sharp decline in NROE, and this belies a historic performance that has seen NROE average 47% over the last five years. Importantly, throughout the five years’, operating cash flow exceeds reported profit and so the profits are real.

Click to enlarge

Source: StocksInValue

The big question in determining the valuation of TRS is the forecast of profitability (NROE). I do not expect to return to 40% but do expect that a focused management team can lift it back towards 30% over the next few years. It is observable that a focus back on operating margins would see pre-tax profit lift by $7.5 million for each 1% of improvement. Indeed, that is all that has to be assumed to see a valuation target of $12.10 in mid-2015 and so a total return of about 35% is possible from TRS in the next 18 months. That looks attractive to me.

Click to enlarge

Source: StocksInValue

Finally, readers should note that Clime Asset Management has become a substantial shareholder of TRS in the recent weeks. We will not be trading the stock and are prepared to be patient as TRS works its way through its short-term issues.

John Abernethy is the Chief Investment Officer at Clime Asset Management. Clime offer excellent performing growth and income portfolios through its individually managed accounts service. To find out more, or to request a review of your share portfolio, call Clime on 1300 788 568 or visit www.clime.com.au.

Growth Portfolio Statistics

Return since June 30, 2013: 6.97%

Returns since Inception (April 19, 2012): 25.80%

Average Yield: 6.01%

Start Value: $141,128.64

Current Value: $150,961.23

Dividends accrued since June 30, 2013: $5,049.21